My most recent essay, War against Gold: Central Banks Fight
for Japan, appears below. Parts of this essay were posted
at www.lemetropolecafe.com
(see Recommended Links) on July 11, 1999. For an interesting
view on Japan and the yen not inconsistent with the views expressed
in my new essay, see "Wading in the yen trap," by Ronald
McKinnon in The Economist, July 24, 1999, page 71.

Copyright 1999 - Reginald H. Howe

WAR AGAINST GOLD: CENTRAL BANKS
FIGHT FOR JAPAN

In The Golden Sextant, I pointed out that gold is arbitraged
like currencies, which is to say on the basis of interest rate
differentials. Currencies with higher interest rates are always
in backwardation against those with lower rates. To that date,
except for six months during the Mississippi Bubble of 1720,
gold had never been in backwardation against any major world
currency. The reason is that the interest rates on gold (today
called "gold libor" or the "gold lease rate")
had never been above the interest rates on any currency. Why?
Gold had always been considered the soundest money and therefore
had always carried the lowest interest rate structure.

1. Hidden War Revealed

Today yen interest rates are lower than gold lease rates.
Accordingly, gold is in backwardation against the yen. This backwardation
may be seen indirectly by multiplying forward gold prices on
the COMEX times like maturity forward yen prices against the
dollar. Thus Monex
(www.monex.com) can now (July
1999) offer "Gold below Spot" on the internet. The
backwardation of gold against the yen can be seen directly on
the Tokyo Commodities Exchange (the "TOCOM") (www.tocom.or.jp),
where at the close July 14, spot gold was Y1001/gram and June
2000 gold Y978.

This situation invites the following trade. Sell COMEX gold
for dollars; put the proceeds in short-term notes at 5%; and
buy an equal amount of gold forward in yen at a lower effective
dollar price. Even if the yen exposure is hedged, the cost of
the hedge is unlikely to exceed the spread between the short-term
dollar interest rate and the gold lease rate. (Note: gold lease
rates are rising, but as of July 15 the 1-year lease rate was
about 2.2%.) In other words, a holder of gold today can maintain
his long gold position (on paper at least) while at the same
time earning more than twice the gold lease rate (if he assumes
the risk of yen appreciation). Under these conditions, it is
not surprising to find most of the open interest on the COMEX
in the nearby months (sellers?) and most of the open interest
on the TOCOM in the furthest out months (buyers?).

It is even more instructive to view gold's backwardation from
a Japanese perspective. Suppose I am Japanese; I earn my living
in yen, keep my savings in yen, and think in yen. With yen interest
rates at one-half of 1%, and in light of the banking and economic
problems in Japan, I begin to think of converting some of my
yen savings to gold. But when I check the prices on the TOCOM,
I discover that I will pay around 2% less for gold to be delivered
to me next summer than today, and I can keep earning my measly
half a percent in the interim. That looks like a pretty good
deal, as long as I can trust the TOCOM to make good delivery
next year.

Judging from the TOCOM's historical volume figures, many are
starting to think along these lines. Gold volume for June 1999
exceeded 1.8 million contracts, almost twice that of any preceding
month. Is it any wonder? Effectively, Japanese are being paid
to defer their urge to convert yen to gold, and the TOCOM is
running a huge gold loan by its customers.

But this is not an activity without risk -- a risk not as
well-understood today as in the era of free gold banking. Currently
the net short gold position of TOCOM members is about 90,000
contracts, or 90 metric tons of gold (each contract representing
1 kilo). The vast bulk of this net short position is held by
two companies: Mitsui and Sumitomo. "Net short" means
that they do not have an offsetting long contract on the exchange.
If they have hedged their exposure, they have done it elsewhere.

What many used to trading commodities often don't appreciate
is that in the currency and gold markets, exchange rates (the
dollar gold price being an exchange rate) are set at spot. Future
exchange rates are simply the product of interest rates (the
gold lease rate being an interest rate) and arbitrage. I have
$100; it earns interest at 5%; a year from now I have $105. I
have Y100; it earns interest at one-half of 1%; a year from now
I have Y100.50. Therefore, if today $1 buys Y120, I can choose
now between having $105 next year or Y12060, which I will have
if I convert my $100 to yen and invest the Y12000 at half a percent.
This calculation suggests that one year from now, the exchange
rate should be about $1 to Y114.85. Accordingly, if I wanted
today to buy a one year forward contract for yen against the
dollar, I would expect to get a rate around this level, which
is in fact quite close to that actually quoted on these approximate
figures. Were it otherwise, I could make a riskless profit by
arbitraging my $100 against my forward yen contract.

On the other hand, if I want to buy oil, copper or orange
juice one year forward, I have no interest rate to use, and without
looking up the prices, I do not even know if they will be in
contango or backwardation. Put another way, all the judgments
that go into setting futures prices in commodities are distilled
in the interest rates for currencies and gold.

The Bank of England's gold sale has generated considerable
comment, much of it quite wide of the mark. In sum, the BOE's
action unmasks what before was only suspected by a few goldbugs:
that the major central banks have mobilized their nations' gold
reserves to support low Japanese interest rates, and thereby
(or so they hope) save the Japanese banking system from complete
collapse. The timing of the BOE's announcement, the manner in
which the BOE is executing the sale, and the purported reasons
advanced to justify it leave no other rational explanation. What
is more, by pulling away the mask, the BOE has revealed the true
motivations for many if not all major central bank gold sales
since 1995, some of which at least standing on their own could
be plausibly explained.

2. Threat from Gold: When and Why the War Began

Gold has been in backwardation against the yen since Japan
lowered its interest rates to about their current level in mid-1995.
At that time the backwardation was not quite as pronounced as
today because gold lease rates were lower. Indeed, gold lease
rates to that date had usually been under 1%, with only occasional
spikes to the 2% to 3% area. Almost immediately after Japan's
action, gold lease rates started moving higher, reaching well
over 3% by the end of 1995. At the same time, the gold price
began to awaken from its slumber at around the $380/oz. level.
All this was a quite normal market reaction to something that
had not been seen in nearly 400 years, a paper currency challenging
gold as the world's lowest interest rate money. And the markets
were about to award gold the victory. The yen and the Japanese
banking system were headed over the cliff, and their fall would
have had huge implications for the world economy in general and
the international financial system in particular.

It is instructive to review gold's press clippings for 1994-1996.
1994 was a year of relative quiet in the gold market, which did
not receive any real discussion by the BIS in its 65th annual
report (year ending March 31, 1995). 1995 began in the same manner,
with gold continuing to trade in a narrow band around $380/oz.
But toward the end of 1995, gold began a rally that carried it
over $400 in early 1996. Noting "the extraordinary rise
in gold lease rates" at the end of 1995, the BIS in its
66th annual report cited "gold lenders follow[ing] their
usual practice of reducing their credit exposures at end-year,"
explaining that "those who needed to borrow gold to sell
it short had to offer unusual compensation." So too, a story
headlined "Sharp Rise in Gold Lease Rates Revives Market"
in The Wall Street Journal on December 5, 1995, noted
that lease rates had fallen back the prior two days as "central
banks and other investors made more metal available,...in part
because of persuasion from the Bank of England, the unofficial
custodian of the world's bullion market." And for the first
time in several years, gold analysts and investors were showing
bullish optimism. At the annual gold roundtable of The Wall
Street Transcript in December 1995, not a single one of the
six analysts present expressed any serious worry over negative
effects on the gold price from unusually high central bank gold
sales or gold loans in 1996.

But what a difference a year makes. By the end of 1996, the
gold price was in rapid descent, falling to around $345/oz. in
early 1997, and touching well below $300 by the end of that year.
In its 67th annual report (year ending March 31, 1997), the BIS
said little about the price of gold but quite a lot about gold
leasing. After describing the increasing volume of gold trading
in the London market ($11 billion per day in December 1997),
the BIS noted (with accompanying chart): "Although the three-month
lease rate shows considerable seasonal variation (with end-year
spikes reflecting a reduction in the supply of loans available
for loans extending beyond 31st December), a longer-term uptrend
can still be discerned." And it added: "In particular,
in the early 1980's gold deposits rarely yielded over 1%, while
more recently they have rarely yielded less than 1%."

Not until its 68th annual report did the BIS address the falling
gold price per se, noting that it had "responded
to Asian developments and declining world inflation." And
it added: "Observers also cited official gold sales, Germany's
decision to lease official gold and a proposal to sell Swiss
gold reserves in explaining gold's weakness." In its most
recent 69th annual report for the year just ended, the BIS makes
no significant mention of gold. But it discusses at length the
continuing seriousness of the deflationary problems in Japan,
stating: "The worsening of the economic outlook came at
a time when the traditional interest rate channel of monetary
policy seemed likely to be of limited effectiveness." It
added: "Additional relaxations of policy took place in February
1999, when the call money rate was reduced to 0.15% or lower,
and in early March, when massive liquidity injections by the
Bank of Japan effectively pushed the overnight rate down to zero."

In December 1995, a highly regarded Swiss private banker (today
retired), wrote in his monthly market commentary to clients:
"The foundation for a gold bull market has been laid; all
that is missing is a catalyst which can spark a takeoff in the
fascination with the yellow metal and its character as permanent
money. A heightening of the banking crisis in Japan could be
such a trigger." And that is why four years ago the central
banks' started their war on gold, and why they continue it today.
It is one front in the larger war to rescue Japan's banking system
before its failure brings down the entire international monetary
system as it has developed since President Nixon closed the gold
window in August 1971, ending the post-World War II system agreed
to at Bretton Woods in 1945.

3. From the Front: The Battle Rages

It may seem strange that the world's biggest holders of gold
are distressed when its price and yield rise. But their real
power and influence come not from their gold, but from their
power to issue paper currency. Yet they know that gold, as the
ultimate money, is also the ultimate judge of their performance.
The gold price, then, is a sort of thermometer measuring current
inflationary heat and the general level of public confidence
in paper currency. Gold lease rates, on the other hand, are more
like a barometer, measuring credit pressures in gold banking.
But central bankers, unlike weathermen, can often -- at least
for a while -- affect the very pressures they are measuring,
and thereby even lower the temperature. But they do so at their
peril because in a real gold banking crisis, unlike a modern
commercial banking crisis, there is no lender of last resort.
The Fed will never run out of dollars; the Bank of Japan will
never run out of yen; but both -- and all the central banks together
-- can most assuredly run out of gold.

Most particulars of the BOE's gold sale have been sufficiently
dissected elsewhere. Two, however, require special mention. First,
that it was the BOE that acted, and that it acted so publicly,
is important because, as already noted, in the cozy world of
central bankers, it is the BOE that historically takes principal
responsibility for overseeing gold and gold banking. Its brazen
action suggests that no other central bank was willing to make
further gold sales in the usual covert manner, or that the situation
was grave enough to require immediately either a public hit to
the gold price or a public reassurance to gold borrowers, i.e.,
gold shorts, that more gold would be made available for loan
rollovers. In this connection, it is worth noting that at the
time of the BOE's announcement, not only was gold threatening
to break $300/oz., but also the IMF had just postponed an expected
decision formally to ask its members for authority to sell gold.

Second, and perhaps more intriguing, it is possible to read
between the lines of the most recent annual report of the BIS
a reluctance by that institution to continue to support Japan's
insanely low interest rates, particularly if to do so would put
at risk the BIS's own gold or balance sheet. Ordinarily, when
national central banks cannot for some reason act on their own
to address a serious international financial problem, they act
collectively through the BIS. But this type of action, of course,
requires the support of the BIS's management. In this context,
the recent remark of high BIS official bears repeating. Commenting
on the large short position in gold, he observed: "Gold
will take few prisoners."

Split or not among the central bankers, the BOE's gold sale
has generated huge negative political fallout. It has galvanized
strong opposition both to further official gold sales and to
the proposed sale of IMF gold to raise funds for debt relief
for poor countries. Opponents include: most of the poor countries
themselves, many of whom mine gold or depend on receipts from
migrant workers in South Africa; the new government in South
Africa; the Black Caucus in the U. S. Congress; several powerful
members of the House and Senate, some of whom come from important
gold-mining states; and most of the world's major gold-mining
companies. Indeed, the proposed sale of IMF gold looks to be
heading for a brick wall in the U. S. Congress, where under IMF
rules it must be approved. Thus stubborn reluctance by the Clinton
Administration to dropping this proposal will indicate a high
level of concern about something other than simple debt relief
for poor countries.

The BOE has also given a huge boost to a relative newcomer
to the world of gold: GATA, or the Gold Anti-Trust Action Committee.
It seeks to mount an antitrust action against the principal gold
bullion banks for manipulating the gold price, all as explained
at its website (www.gata.org).
In essence, GATA alleges that the major bullion banks are in
a cabal with the central banks to manipulate the price of gold
for the benefit of the bullion banks. GATA has lined up a respected
law firm, raised money, and started a hard-hitting investigation
of the recent activities of the bullion banks. In addition to
promoting its cause on the internet at both its own site and
www.lemetropolecafe.com
, GATA also engages in political lobbying. It has become
a force to watch, and potentially a very troublesome one for
the central banks and the gold shorts in particular.

From the perspective of a central bank, interventions in the
gold market, whether sales or loans, are like interventions in
the foreign exchange markets, a tool for carrying out what it
perceives as its official mandate. And just as it reaches into
the foreign exchange markets through the commercial banks, it
reaches into the gold market through the gold banks. When a central
bank "loans" gold to a bullion bank, it "deposits"
gold to its interest bearing account at that bank. The bullion
bank will then "loan" the gold to its customer at a
higher interest rate, making the spread, and its customer will
generally sell the gold to raise currency. Of course, if the
bullion bank knows that central banks are engaged in concerted
"interventions" specifically directed at holding down
the gold price, it has greater opportunity to profit from the
sale or short side of the loan transaction because it has less
need to hedge as aggressively as it would in a truly "free"
gold market.

GATA is dangerous to the central banks and the bullion banks
not just because it threatens to focus the public spotlight on
their symbiotic relationship, but also because it does so in
a manner that suggests these activities are much more about greed
and political corruption than any legitimate public purpose.
Both central banking and gold banking are hard to explain to
anyone, and more so to a general public that has been trained
to think of gold as a commodity rather than money. Scandal, on
the other hand, is easy to sell to a public full of distrust
for politicians and their wealthy supporters. In any event, whatever
the merits of its proposed lawsuit, GATA has performed a valuable
function by uncovering much information about the recent workings
of the gold market, a large part of which is private and invisible
to the public.

4. What to Watch: Physical Demand and Gold Lease Rates

Interventions by the central banks may have denied gold an
early TKO against the yen, but gold is a master at the "rope-a-dope"
strategy. It bobs and weaves and looks increasingly wobbly, as
if it's about to be taken out. All an illusion, for gold is a
fighter with explosive hidden power. The two things to watch
are physical demand for gold and gold lease rates, particularly
when they become inverted.

Today the physical gold market is in deficit, meaning that
annual demand for gold exceeds annual new supply. New production
now runs about 2500 metric tons per year. Figures vary, but annual
offtake of physical gold appears to be running at about 3500
tons. Furthermore, there has been a significant supply deficit
for several years. In short, there are still plenty of buyers
of physical gold, especially in Asia, where the demand is quite
elastic. Accordingly, lower gold prices tend to push up physical
demand and drain physical gold from the market. Gold loans by
central banks (or others) help to meet this demand without driving
the price of gold higher.

At about $260/oz. now, the price of gold is well below the total
cost of production for most gold-mining companies, and below
the cash cost for many. New projects are being delayed or canceled.
In sum, the situation in the gold-mining industry is reminiscent
of the late 1960's, just before the collapse of the Bretton Woods
system with its fixed $35/oz. gold price. Martin Mayer tells
an interesting story about this period in his 1980 book, The
Fate of the Dollar. Six months before the first upside breakout
in the London gold market, George Champion, president of Chase,
called a young Paul Volcker into his office to ask whether the
then unfolding balance of payments problem might cause the U.
S. to start losing gold. Volcker explained that the dollar was
healthy and the gold market unimportant. "It was,"
Volcker said later, "one of the most embarrassing moments
of my life."

Although today's shortage of physical gold is not yet evident
in the gold price, it is quite evident in high gold lease rates,
which are now also inverted or partially so. Inverted interest
rates are almost always a sign of stress in the banking system.
So too, inverted gold lease rates, particularly if they remain
inverted for more than a short time, are a warning of problems
in the gold banking system. A rise in gold lease rates across
the maturity spectrum (lease rates are quoted at www.kitco.com
for 1 month, 3 months, 6 months and 1 year) suggests generally
increased demand for borrowed gold to sell into the physical
market, and is consistent with selling to take advantage of gold's
backwardation against the yen. On the other hand, inverted lease
rates (nearby gold commanding a higher lease rate than longer
maturities) can suggest that existing shorts are having difficulty
meeting delivery commitments or rolling over loans as they come
due. In recent years inverted lease rates have also been associated
with year-end withdrawals of gold from the loan market by central
banks anxious to clean up their balance sheets for reporting
purposes (i.e., hide the full extent of their exposure
to the gold loan market), and with large sales by central banks
or others that either remove gold previously on loan or put short-term
pressure on the physical supply.

Alan Greenspan twice testified before Congress in 1998 that
"central banks stand ready to lease gold in increasing quantities
should the price rise." Many have interpreted this remark
as suggesting an attempt by the G-7 central banks to thwart gold
from signaling any incipient inflation, thereby foreclosing early
calls for monetary tightening. But his statement is equally consistent
with the view that the G-7 central banks will continue to support
the demand for gold loans precipitated by gold's backwardation
against the yen. At $260/oz., the gold price is far from giving
a warning of imminent inflation. If the central banks continue
in these circumstances to provide gold to the bullion banks,
they are worried about something else. And they are continuing
to set the stage for a classic gold banking crisis, something
not seen since the Great Depression.

5. Bubbleland

The war against gold is but one front in the effort of the
G-7 nations and their central banks to save Japan's banking system
and economy from complete breakdown, the consequences of which
are almost too dire to contemplate: calling of Japan's foreign
loans; sale of its hoard of U. S. Treasuries; massive depreciation
of the yen; in short, the sort of collapse experienced by some
of its Asian neighbors but in an economy far larger and far more
important to the world. The fundamental strategy has been to
try to keep Japan afloat on a sea of liquidity -- liquidity that
has gushed out of Japan into other major markets, particularly
in the United States and Europe.

Mirroring but on a far larger scale what has been happening
in the gold market, the so-called "yen carry trade"
-- borrowing yen at low interest rates in order to invest in
other higher yielding assets -- has supported stock and bond
markets outside Japan even as its own markets struggled. From
mid-1995, when Japan sharply lowered its interest rates, to August
1998, when the Long Term Capital Management (LTCM) hedge fund
crisis hit, the yen fell from about 90 to the dollar to 145.
Borrowing at one-half of 1% a currency depreciating at an annual
rate of around 15% is a pretty good deal, not to mention the
return earned on the borrowed funds.

When the near bankruptcy of LTCM shook the world last August,
the yen began a sharp recovery from 145 to less that 120 to the
dollar in a couple of months, largely testimony to effects of
leverage as shorts run for cover. More worrisome, however, was
the simple fact that a single hedge fund through the use of leverage
and derivatives could put itself in a position where its failure
could threaten to seize up the entire international financial
system. Nor was the gravity of this fact lost on the BIS, which
devoted several pages in its most recent annual report to the
dangers illustrated by the LTCM incident.

Almost a year later the yen remains relatively strong at around
the 120 level despite a continued absence of loan demand in Japan.
Now the demand for yen appears to come largely from investors
anxious to buy Japanese stocks. But the Bank of Japan, fearful
that any rise to much over 120 will choke off Japan's nascent
recovery, thwarts any move much above this level by selling yen,
thereby inviting more yen borrowing by foreigners.

Meanwhile, particularly in the United States, a financial
bubble of historic proportions continues to grow even as it emits
an increasing number of danger signs. Their catalog and analysis
is beyond the scope of this article, but the notion that gold
is being "demonetized" is as much a part of "new
era" thinking as the notions that historic benchmarks of
stock valuation are passe or that profits don't matter, at least
for internet companies. Yet like the Bank of Japan a decade ago,
the Fed seems immobilized by fear of triggering a stock market
collapse, and like the Japanese economy then, the U. S. economy
now is at the mercy of such a collapse.

Nor can much comfort be found in the apparent absence of consumer
price inflation. None of the great stock market bubbles in history
-- neither the Nikkei in the 1989, nor Wall Street in 1929, nor
the Mississippi Bubble in 1720 -- was accompanied by consumer
price inflation. In all those cases, as today in the United States
and Europe, the credit inflation went into stocks.

A recent online poll of U. S. college students showed that
twice as many expect in their lifetime to see aliens land on
Earth than to experience another Great Depression. The beanstalk
let Jack capture the hen that laid golden eggs; today's tall
trees on Wall Street are providing investors a unique opportunity
in gold-mining shares.

6. Checkmate: How It Will End

Whether the recent bounce in the Nikkei signals the beginning
of a real recovery in Japan or another false start is the question
of the hour. But the consequences of either may be grim for the
U. S. stock market, now far into bubbleland.

A real recovery in Japan, particularly if it brings the rest
of Asia along with it, is almost certain to put upward pressure
on prices in the commodities and some consumer markets. That
whiff of inflation by itself could be enough to tank the U. S.
stock market. In any event, a real recovery in Japan that leads
to more normal interest rate levels for the yen should cause
both the yen carry trade and gold's backwardation against the
yen to reverse, draining the liquidity which they had provided,
and quite likely causing upward spikes in both the yen and gold,
with concomitant downward pressure on the dollar and upward pressure
on U. S. interest rates. None of these events bode well for the
U. S. stock or bond markets.

On the other hand, a continued absence of recovery in Japan must
at some point adversely impact the yen, a collapse of which against
the dollar will export Japan's deflation to the rest of the world.
Whichever way Japan falls, the nub of the problem is how to freeze
the bubble that the U. S. stock market has become, as have some
European stock markets as well. It is a long way from where these
markets are today to even normal valuations. The history of bubbles
is not one of slow, controlled deflations, but of sudden, sometimes
cataclysmic, crashes.

Of course, predicting exactly what pin will provide the fatal
prick is almost impossible. Even after the event, there may not
be agreement on the immediate cause of the collapse. What is
more, the world today presents a number of potential military
flashpoints, any one of which could explode sufficiently to puncture
overvalued western markets. In truth, the effort to rescue Japan
has created a credit bubble bigger than that which caused Japan's
troubles in the first place, and this bubble has now left the
G-7 countries hostage to events over which they have little or
no control.

But there is good news. With their four year war on gold,
the central banks have virtually assured that when it arrives,
a U. S. stock and bond market collapse will either bring with
it a classic gold banking crisis or be the result of one.

What is a gold banking crisis? In essence it is a failure
of confidence in the promise of gold banks to deliver gold,
i.e., a "bank run" or a "panic" to our
grandfathers. The equivalent today would be gold $1000 bid, none
offered, underlining the key point: In a true gold banking crisis,
customers demand delivery of physical gold. They want the asset
itself, not a promise that is someone else's liability.

And why would a gold banking crisis be good news, other than
to the few who had the luck or foresight to profit from it? Because
it would force serious rethinking and likely meaningful reform
of the international monetary system that caused it, all to the
benefit of future generations who would enjoy, as did our forefathers,
the blessings of honest money. This happy prospect will be discussed
in my next essay: The Golden Millennium: Aftermath of the
Gold Banking Crisis of 1999-2000.